Why We Need Fannie and Freddie

With their recent earnings announcements, Fannie Mae and Freddie Mac have now repaid all but about $4 billion of the $189 federal bailout that kept the two government-sponsored enterprises (GSEs) afloat after the financial meltdown five years ago.

Politicians of both parties have responded curiously to this good fortune. Sens. Bob Corker (R-Tenn.) and Mark Warner (D-Va.), most prominently, find Fannie and Freddie irredeemable and have offered a complex bill that would replace the companies with a system of government guarantees—and the hope that giant New York banks will fill the gap. Lawmakers are preparing to do to GSEs—and the housing sector as a whole—what the Affordable Care Act is doing to the health care sector, a comparison others have noted: Each bill is a kind of kludge, a needlessly complicated system in which ill-fitting parts are added to try to make up for the deficiencies of other ill-fitting parts. Sound familiar?

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Now, instead of being on the brink of success as independent businesses, Fannie and Freddie are on the brink of extinction—a huge risk for the whole country. The two GSEs that have been a source of liquidity and stability for the housing market for 75 years—and were essential in pulling residential housing out of the ditch over the past five years—could soon be gone. There is no doubt that, partly because of pressure from Congress to lower their credit standards, Fannie and Freddie screwed up badly. But today they are chastened and reformed, the mortgage market is humming and home prices are rising. This is no time to take chances with a new system.

There is no doubt that Fannie and Freddie are in a position to thrive on their own. Fannie, now managed conservatively and with renewed focus on its core business, earned a whopping $8.7 billion in the third quarter this year. That’s more than both GSEs earned in all of 2005. Freddie earned some $31 billion for the quarter after accounting for a tax adjustment. All of those profits will go to the U.S. Treasury in another few weeks. In 2008, Treasury also received 80 percent of the common stock of the two GSEs, which, at current market prices, is worth another $20 billion—and could eventually be worth a lot more. (Private investors, including community banks, insurance companies and individuals, own the rest of the common plus junior preferred stock.) Treasury will be completely repaid for its loan by the spring, and it can sell its common shares and pocket a nice profit.

Meanwhile, the GSEs have already been reformed to a significant degree in ways many of us advocated before the meltdown: They have a strong regulator, the Federal Housing Finance Agency. They are back to the business of buying up loans made by banks and other lenders, packaging them, guaranteeing them and selling them to investors around the world as mortgage-backed securities, or MBS—but they have stopped speculating in MBS themselves. The new mortgages they guarantee are solid credit risks. Since 2007, the average GSE borrower’s FICO credit score has gone up 50 points. And in fact, three-quarters of Fannie’s single-family loans were made in 2008 or later, after the bubble had popped and prices became more realistic.

So why not let the GSEs continue to do what they started doing back in 1938?

That was the path for other financial institutions that received government support during the crisis. At the end of 2012, for example, Treasury sold the final portion of its common shares in the giant insurer AIG and, in all, made a profit of $23 billion on a 2008 outlay of $182 billion—figures similar in scale to the GSEs today. In August, AIG started to return capital to private shareholders through dividends and share buybacks.

Washington, however, has decreed a different fate for Fannie and Freddie. Because of a 2012 amendment to their original deal with Treasury, the GSEs are required to send the government all their profits with no time limit—even after the original money is repaid. While the GSEs are easily capable of raising their own capital, the Corker-Warner bill, which President Obama backs, as well as legislation in the House, prefers to relegate them to the dustbin of history.

Without Freddie and Fannie, how will the broader mortgage system perform? No one knows—just as no one knew the effects of Obamacare. (And at least Obamacare had a justification as a way to provide health insurance to millions who don’t have it.) We can certainly take a guess that the large banks that are supposed to fill the gap when the GSEs are vaporized will have less expertise—and probably less enthusiasm. Rates for homeowners will certainly rise.

“Why destroy something that’s working?” says Tim Pagliara, a Corker fundraiser-turned-critic who is founder of CapWealth Advisors in Franklin, Tenn. Pagliara bought $9 million worth of GSE junior preferred stock for his clients in 2008 and 2009. He had faith that Fannie and Freddie would quickly recover, and he was right. What he missed was that so many politicians would want to destroy Fannie and Freddie and, like the Romans at Carthage, sow the fields with salt. Another Tennessee investor, Woody Woodruff, a Nashville attorney, told me, “I have a bias toward the rule of law.” Instead, what the federal government is doing is “more like Tony Soprano”—that is, becoming a partner and then taking all the profits.

A Congressional Research Service study, published in August, said that if Fannie and Freddie “become financially viable, they could return to shareholder control.” They have clearly reached that stage, and shareholder control is the least disruptive, most equitable solution—and the best way to provide the liquidity that keeps the vast U.S. mortgage market afloat and keeps housing affordable to two-thirds of Americans.

There’s a simple solution: Reform the GSEs; don’t replace them. Set strong capital requirements. Get rid of any implicit or explicit guarantee from the federal government (the Corker-Warner bill, by contrast, adds a $5 trillion liability to the federal balance sheet). Let Fannie and Freddie compete on equal terms with other financial companies. And banish the political meddling that precipitated the mortgage meltdown in the first place.